Theories of the Stock Prices

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Anticipating changes in earnings
precipitates a change in stock prices. According to the
theory, an astute investor analyzes the fundamentals of a company
regarding its effects on future earnings. When future earnings are
expected to rise, the stock price increases in advance of the actual
changes in earnings. The belief is that by buying and selling stocks
in advance of their changes in earnings, investors will increase
their returns. In other words, it would be too late to buy stocks after
earnings increases are announced or to sell them after decreases in
earnings are announced because the stock price would have
already reacted to this news. However, if earnings were expected to
continue their growth, investors would continue to buy these stocks.

A fundamental analyst is concerned with the financial characteristics
of different stocks in order to find stocks that are undervalued.
When the market price of a stock is less than its intrinsic value
(a reflection of estimated earnings multiplied by a price/earnings
ratio), the stock is undervalued. If the market price is above the
intrinsic value, the stock is overvalued. This theory then implies that
stock markets are inefficient, allowing for large profits to be made
from undervalued securities.

What are some possible reasons that fundamental analysis
may not work? Burton G. Malkiel, an economics professor at
Princeton University, suggests three reasons in his book, A Random
Walk Down Wall Street (1990, p. 124):

1. The information collected by the analyst may be based on
assumptions and bad information. The analyst may be
overly optimistic about assumptions on future sales, cost
containment, and earnings that may not materialize,
causing earnings disappointments.
2. An analyst may be missing the mark on value. Analysts
may agree that a stock is growing at a certain percentage,
but they may be incorrect in their perception of value. For
example, some analysts agree that Pfizer is growing its
sales into the future because of its pipeline of new drugs
still to be released to the market, but their assumptions
on the future value of Pfizer’s stock may be incorrect.
3. The market may not value the stock in the same way as
the analyst does. For example, Cisco stock is currently
trading at a P/E multiple of 26 times (its earnings) with a
growth rate of around 11 percent. The market might have
viewed the stock as overvalued even though analysts still
tout the value of Cisco. Rather than increase in price,
Cisco’s stock price decreased, which brought its P/E
multiple down from its lofty levels.

Fundamental analysis may not always work and has been
refuted by the efficient market hypothesis (discussed later in this
section).

Because you have no assurances that stock prices will always
move in the same direction as earnings over short periods of time,
you might not be able to count on correctly forecasting stock price
movements. Moreover, a multiplicity of conditions and factors
over and above the fundamentals affects stock prices.

Technical factors, which, unlike fundamental
factors, affect stock prices because of conditions within
the market. Technical analysis ignores the company’s earnings,
dividends, and factors in the economy such as interest rates as the
cause of stock price changes. Instead, the focus is on past stock
prices, their patterns, and trading volume. By charting these past
price movements and volume, technical analysts forecast future
price movements. Their belief is that past price patterns will be
repeated, which is the basis for their recommendations about when
to buy and sell stocks. Technical analysis has little support from
the academic investment literature. The academic world not only
has not been kind to technical analysis, but technical analysis
also has been disdained by supporters of the efficient market
hypothesis.

The Wall Street investment community’s two methods for
choosing stocks, fundamental analysis and technical analysis, have
their limitations, as has been pointed out. Academicians, on the
other hand, have their own theories, which they have advanced to
explain the movement of stock prices. To recap, the Wall Street
fundamental analysts believe that individual investors are totally
lost without their recommendations and that investors will always
underperform analysts. Academicians, on the other hand, have
come up with a number of theories related to the dissemination of
information that affects stock prices:

* If information were random, a randomly selected portfolio
chosen by throwing darts at the names of stock companies
would do as well as a portfolio carefully selected by analysts.
* If information about stocks is disseminated efficiently, stock
prices will always be fairly valued.
* The capital asset pricing model (CAPM) states that a security’s
expected return is directly related to its beta coefficient
(which is its rate of return relationship to the market index).
* Market information is disseminated inefficiently in the
stock market, and stocks with low price-to-book ratios
show greater returns than high price-to-book ratios.

These theories are discussed in detail in this chapter. By understanding
the different theories of stock prices in the market, you will
be better prepared to formulate your own investment style in the
construction of your portfolio.